Pall Management Discusses Q4 2013 Results - Earnings Call Transcript

Aug.29.13 | About: Pall Corporation (PLL)

Pall (NYSE:PLL)

Q4 2013 Earnings Call

August 29, 2013 8:30 am ET

Executives

Lawrence D. Kingsley - Chief Executive Officer, President, Director and Member of Executive Committee

Akhil Johri - Chief Financial Officer

Analysts

Kevin R. Maczka - BB&T Capital Markets, Research Division

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

Derik De Bruin - BofA Merrill Lynch, Research Division

David L. Rose - Wedbush Securities Inc., Research Division

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

Paul Richard Knight - Janney Montgomery Scott LLC

Jonathan P. Groberg - Macquarie Research

Brian Drab - William Blair & Company L.L.C., Research Division

Operator

Welcome to Pall Corporation's Conference Call and Webcast for the Fourth Quarter and Year End of Fiscal 2013. Today's call is being recorded and simultaneously webcast. [Operator Instructions] We'd like to remind you that the company's fourth quarter press release is available at www.pall.com.

Management's remarks this morning will include forward-looking statements. Please refer to Slide 2 or request a copy of the specific wording of this qualification of the company's remarks. Management also uses certain non-GAAP measures to assess the company's performance. Reconciliations of these measures to their GAAP counterparts are included in the slides at the end of the presentation.

At this time, I will turn the call over to Mr. Larry Kingsley, Pall Corporation's President and CEO. Please go ahead, sir.

Lawrence D. Kingsley

Good morning. Thank you, Stephanie. As is typical, all of our remarks this morning will be made on a continuing operations basis. I'm here today with Akhil Johri, our CFO; and Brent Jones, who is our VP of Finance and our Treasurer.

I'll begin with recapping the year, coupled with a sense of what we're seeing out there. We'll then run through the quarterly and annual numbers and conclude with fiscal year '14 guidance. I know that most of you have read our press release and know the key headline. We executed a good fourth quarter and turned in very solid results for the full year.

Our pro forma EPS for Q4 was $0.90 and our full year EPS of $3.04 was near the top end of our most recent guidance. Given the challenging environment, particularly in certain industrial end markets, we're delivering pretty good bottom line performance. We continue to see weakness in the world's industrial economies, though particularly as it relates to capacity expansion. Several of the emerging country economies that had been infrastructure-focused have moderated. However, many of our global end markets are fundamentally healthy and fairly immune to the macro issues. In general though, our consumables business model serves us well in this slow-growth, weak capital spend environment.

All-in for 2013, our revenue was up 1% year-over-year, ex FX, with our Industrial business down 4%. However, despite this weak top line, we delivered EPS growth of 9% and 12% if you exclude the effect of translational FX. Another good way to characterize FY '13 is as a good strong step in a multiyear journey. We still have more to do, but I'm pleased with the progress we've made.

Accordingly, some of the highlights and areas of current focus are as follows. First, operations. As I've described throughout the year, we're in the midst of an operational transformation. We've done or are in process of doing all the things you'd expect. We're rationalizing our footprint, improving productivity across the enterprise and reducing input costs as per our strategic sourcing initiatives. And while we're early along the path toward operational excellence, we're now making just great progress.

More importantly, we've improved how we serve our customers. Every important customer service metric we track has gotten better, dramatically in some cases. For example, we improved on-time delivery by 16 percentage points in the year and we reduced our past due delivery by 74%. That's from $25 million to $7 million. That's a significant 1-year improvement. Bottom line, on an operational basis, we're now very well positioned to take advantage of any uptick in volume that we can generate.

Second, R&D. As we indicated at the beginning of the year, our R&D spend is up. But it's not just about spending more, it's about spending smarter. We are investing for innovation. For example, in the past year, we had 160 invention disclosures and 27 original patent applications, more than double our average annual performance for the last decade. Furthermore, on the commercial side, we've begun to see the impact of our reinvigorated, commercially focused R&D approach, with our BioPharm, Medical and MicroE businesses in particular all benefiting.

And the multiyear restructuring plan. As we've promised, our restructuring plan yielded over $50 million in cost saves in '13. And we're on track to complete the program with incremental savings of $25 million per year in FY '14 and '15. Despite this accomplishment, we have more work to do to size and allocate our cost structure more appropriately to our business model. In these uncertain times, it does provide us with an opportunity that many others don't have. So it's further ground for further cost improvement.

And then systems. So everyone's clear, when I discuss systems, I'm referring to the large capital goods that hopefully include consumable elements. Throughout the year, we've discussed our performance in systems and the challenges this business has been facing. While there has been some pressure on capital spend globally, we're also in the midst of a shift in strategy that I've mentioned on prior calls. You can see the effects of both in our current order rates.

As a general matter, we're in the systems business to drive consumable pull-through or some form of recurring revenue. If a systems sale doesn't provide that entitlement, particularly given the systems' generally lower-margin profile, that's business that we're unlikely to pursue going forward on our own. But we will work with systems integrators as key technology providers to ensure that we build in the consumable opportunity. That said, systems will continue to be an important part of BioPharm, Food & Beverage and our Industrial process end markets. As a result of the actions we've taken, combined with the current pressure on capital spend, you'll see systems as a smaller part of our revenue mix in the future but a more profitable one.

So shifting to what we're seeing out there. The macro environment continues to be a mixed one. While there is select strength around the globe, including in the U.S., there continues to be significant pockets of weakness in what had been higher-growth emerging markets. And I'd say cautious and uncertain are fair descriptors.

On a regional basis, we continue to perform well in Europe. As you'll recall, a significant portion of our Life Sciences sales originate in Europe for global end market consumption. But our European performance isn't just driven by end markets. Our sales execution continues to be excellent. And we're doing what good sales organizations do, staying close to our customers, providing better service. And as a result, we're gaining share. So this continues to be a counterintuitively very strong element of our business for us versus many others. We're turning the corner in Asia after a difficult rebuilding year in '13. And Asia had a good Q4, as our organizational changes are beginning to bear fruit. Finally, while the Americas was down for the quarter, this was largely due to a tough year-over-year comparison. Our end markets in the Americas are performing well.

In summary, it continues to be a very dynamic economy, without tremendous need for capacity expansion. But our combination of operational improvements, a global footprint, a pristine balance sheet and above all, a great fundamental business model, all reinforce my confidence in our ability to generate solid returns in a less-than-completely robust sales environment.

As we review the financial results, I want to point out that Q4 of fiscal '12, that's the 12-month-ago quarter, included the revenue catch-up from supply chain disruptions associated with the ERP system conversion at that time that had negatively impacted Q3 of '12 performance. So bottom line, the comparables are messy, which makes assessing our Q4 year-over-year organic performance a bit more difficult. And I'm on Slide 5 for reference.

Again, excluding FX, sales were flat in the quarter and grew 1% for the year. Overall, sales growth was hampered by weakness in the industrial markets while our Life Sciences segment performed well. Gross margin was 51.5% in the quarter, on par with last year. For the full year, gross margin improved 10 basis points to 51.8%. SG&A was down 1% in the quarter and declined 4% for the year, driven by our structural cost improvement initiatives and some FX benefit. Operating margin declined 50 basis points in the quarter to 18.8% from higher investments in R&D, but improved 70 basis points for the full year to 17.7%. The underlying tax rate in the quarter was about 22%, compared to 24% in Q4 of '12. For the year, the underlying tax rate was 22%, compared to 23% for '12.

Pro forma earnings per share in the quarter were a record $0.90, an increase of $0.04 compared to last year. Bridging this increase, operating profit declined slightly, but that includes a negative $0.03 from Japanese yen-related transactional FX. Translational FX was a $0.03 headwind as well. And our lower tax rate, share count reduction and other items combined to contribute $0.08.

So on flat sales, EPS in the quarter grew about 8%, excluding the impact of just the translational FX component. Again for the full year, pro forma earnings per share increased to $3.04, an increase of $0.24 compared to the prior year. Bridging this increase, operating profit contributed about $0.18. Translational FX was a $0.10 headwind. And our beneficial tax rate, share count reduction and other items combined to contribute $0.16. Again, EPS was up 12%, excluding the impact of translational FX.

So now I'm going to hand it over to Akhil, who will now go through the rest of the numbers. Akhil?

Akhil Johri

Thanks, Larry. I'm on Slide 6. As noted, I will talk to the year-over-year changes excluding FX. Life Sciences sales grew by 6% in the quarter, while Industrial declined by 5%. Consumables, which were about 84% of the sales in the quarter, grew 4% in Life Sciences and decreased a like amount in Industrial. Systems were up 2%. 33% growth in Life Sciences more than offset the 9% decline in Industrial. For the full year, Life Sciences sales grew by 6%, while Industrial declined 4%. Consumables, which were about 87% of the sales in the year, grew 8% in Life Sciences and declined by 3% in Industrial. In total, systems were down 6%.

Turning to Slide 7 and looking at Life Sciences segment. BioPharm consumables sales grew 6% in the quarter and 10% for the year. This reflects continued strength in the biotech sector in all 3 regions, although our Q4 performance was negatively impacted by the messy comps Larry spoke about earlier.

Medical consumables increased 5% in the quarter and 9% for the year on strong growth in Americas. Consumable sales in Food & Beverage were down 4% in the quarter on weakness in Asia and Europe. This was partly mitigated by the impact of geographic expansion in the Americas. For the year, Food & Beverage consumable sales were flat.

Life Sciences systems sales were up 33% in the quarter, with contributions from both BioPharm and Food & Beverage. For the year, systems sales were down 7% on weak Food & Beverage-related capital spend. On the order side, consumables increased 5% in the quarter, principally driven by BioPharm. Systems orders declined in the quarter due to a combination of project timing and weakness in capital spend.

Q4 gross margins decreased 110 basis points to 56.8%. This primarily reflects unfavorable mix from substantially higher growth in the lower-margin systems business and transactional FX impact from weaker Asian currencies. These negative impacts were partly offset by higher pricing. SG&A increased 40 basis points to 27.9%, partially due to higher incentive compensation associated with sales outperformance in the segment. R&D also increased about $1 million or 7%. All-in, segment margin was 24.2% compared to 25.7% last year. For the year, Life Sciences segment margin was 24.4%, compared to 25.5% in fiscal '12.

Turning to the Industrial segment on Slide 8. Process consumable sales grew 1% in the quarter, the first quarter this year with positive year-over-year sales. For the year, process was down 5%. Aerospace consumables were down 10% on a decline in military sales. This decline was partially due to large helicopter program sales in Q4 of last year that did not repeat. For the year, Aerospace sales grew nicely at 7% on strong commercial performance.

MicroE consumables declined about 7% in both the quarter and the year, largely due to continuing weakness in display and data storage end markets. Systems sales decreased 9% in the quarter and 6% for the year. Municipal Water was a key driver, as customers continue to delay capital spend. On the order side, consumables were down 1% in the quarter. Most markets were down with the exception of Military Aerospace, which was up strongly. Systems orders were down significantly, with both energy and Municipal Water showing particular weakness.

Q4 gross margin increased by 30 basis points to 46.3%. This reflects favorable pricing, partly offset by unfavorable market mix. SG&A declined about 13%, reflecting the benefit of our cost improvement initiatives. R&D increased by $2 million or 28%. All-in, segment margin for the quarter improved by 140 basis points to 18.8%. For the year, segment margin improved a solid 200 basis points to 16.0%.

Turning to Slide 9. Operating cash flow in the year was $384 million, compared to $475 million last year. As we have discussed before, this reduction primarily reflects income tax payments associated with the settlement of several years of U.S. tax audits and a gain on the sale of our blood business. CapEx of $110 million was significantly below last year, which included large investments related to our global ERP rollout. Significant uses of cash during the year included $358 million return to shareholders, with $108 million of dividend payments and $250 million of share repurchases.

Finally, on the liquidity front, our cash position stood at about $937 million as of July 31. Our cash position net of debt was $299 million. This compares to a net debt position of $196 million as of the end of fiscal '12. Although our free cash flow generation improved substantially during the fourth quarter, with particular focus on receivables, we have more work to do. We remain focused on improving our balance sheet metrics, particularly on the working capital side, and expect to become world class in this area, similar to what we have done with other operational improvements Larry talked about.

With that, let me turn it back to Larry for what you are primarily interested in, a discussion of the 2014 outlook.

Lawrence D. Kingsley

Thanks, Akhil. Before we talk about 2014, again, my assessment of our current performance would be as follows. In the face of slower industrial end markets, we're delivering reasonable performance to the bottom line. This is largely due to a combination of very solid operational improvements that are now driving productivity; continued strong sales execution in Europe in particular, which is our largest region; solid new product introductions; and what we're realizing now the benefit of our structural cost actions.

We will continue to invest incrementally in sales and marketing and R&D this year, particularly where we see near-term opportunities for organic growth. However, we remain razor-focused on spend control. And it's my intention that such investments will be cost-neutral. Our M&A capability continues to improve and we're actively engaged in proprietary opportunities as well as bank-mediated processes. We're currently assessing several opportunities of varying sizes.

As I've articulated before, our criteria for M&A are both strategic fit and reasonable return on investments. Our acquisition targets emanate from our strategic plan process. And we will remain vigilant and disciplined to acquire what we desire, but also at an appropriate price. That said, valuations remain high relative to growth, inherent return risk, and that's including the combined synergies. To that end, on the shareholder return side, we plan to spend at least $250 million to repurchase our shares in 2014.

Slide 10 depicts our modeling assumptions for the year. You can see the segment expectations for growth, our operating improvements' associated impact, the year-over-year FX impact, our R&D investments and our repurchase assumptions. We expect pro forma EPS in the $3.30 to $3.50 range, reflecting 9% to 15% growth. As always, with nearly 70% of our sales outside the U.S., FX potentially impacts our results, both in terms of our cost of goods base on mismatched cost and revenue domiciles, but also like most, as we consolidate our results. The rates for key currencies being used by us are included in this guidance -- are included here for your reference.

We expect our tax rate to be 23%, slightly higher than 2013, principally due to the geographic mix of earnings. As I said before, there's no substitute for organic growth in terms of delivering bottom line performance. If the macro environment cooperates and as we take share, our improved cost structure should result in healthy incremental margins. However, given the uncertainty that persists and the continuing pressure on capital spend, the team will be working hard to achieve the stated EPS range.

While we don't and don't intend to provide quarterly guidance, our FY '14 plan improves sequentially as the global and industrial end markets slowly pick up, and as our initiatives contribute to performance. Accordingly, you should expect a Q1 that is similar to, or could be slightly weaker, than Q1 of FY '13.

And with that, we'll open the lines now for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Kevin Maczka with BB&T Capital Markets.

Kevin R. Maczka - BB&T Capital Markets, Research Division

Larry, if I could just start with what you commented on at the end of your remarks there on the guidance. Just trying to get a sense for how conservative or not conservative that initial view is on EPS. I think you said that you did achieve your $50 million cost takeout goal for '13 and you're still on track for $25 million in '14. So I guess, if we exclude that $25 million on low single-digit revenue in '14, it doesn't look like that's implying the normal kind of strong 30-plus percent incrementals that I think you've described in the past. Is that the proper way to think about it? And I guess, why would that not be, particularly if systems mix maybe is getting more favorable?

Lawrence D. Kingsley

Well, it's a fair question, Kevin. I think that -- let's take a look at the big picture first. When you think about the current environment, first, on a macro basis, there's still a fair number of mixed indicators out there as to how much growth opportunity there is. And for us, if you look at it relative to history, against the emerging world, we're not going to see the same kind of outpaced emerging world growth going forward that we have, at least not in the very short term. We've taken a pretty muted view, I would say, in total, if you look at all the emerging country economies in aggregate. And then you look at the, kind of what the mature world is contributing. As we've said several times during the prepared remarks, we don't see that there's a huge capacity expansion basis for spend. So we do think that the top line opportunity is still a yet to be determined. And we've maybe taken a slightly conservative approach. So that's the top line environment. To your point, we are now kind of operating the company the way that we should be. We've got our cost management in place. We're beginning to earn the productivity that we've been talking about for a number of quarters in the operations side. And we do feel pretty confident about our ability to earn incremental margin on whatever organic growth we produce. So when we factor in, admittedly so, a kind of a mixed view of the top line but some reasonable confidence on the bottom line, and again, excluding some of the thinking around what happens with FX, both transactional and translational impact, we netted to the stated range that you see there. The good news is any incremental growth beyond what's inherent to the implications that are stated on Slide 10 should convert very well. But I think what we've said by way of inference, if nothing else, is that there's good conversion capability in the company at this point.

Akhil Johri

If I may, Kevin, also just to -- the math would suggest that our incremental margin for 2014 is about 50%, including the benefit of these cost reduction actions. So I think organically, we are talking about the range of 35% to 40%, excluding the cost reduction benefits.

Kevin R. Maczka - BB&T Capital Markets, Research Division

Okay. Yes, that's helpful. Maybe if I could ask one more. You talked about systems, you've talked about it for a number of quarters. It was up big in Life Science, and I'm wondering 2 things. If you can maybe talk about how much that negatively impacted the margin, that growth in Life Sciences mix. And then going forward, Larry, you've talked about it becoming a smaller, more profitable piece of the business. Can you just maybe help us frame that a little bit for next year? Should we see systems dollars down substantially, as you're more disciplined, if you will, about how you take those orders?

Lawrence D. Kingsley

Well, I would again, step one step back and think about the big picture as to how you might model the business looking forward. First, systems historically for us have been between kind of 12% and 15% of total sales. And irrespective of what system mix we've seen within a given year, systems always has a fairly dilutive impact to our margin rate, in the neighborhood of 20 points when you think of average-to-average, systems to consumables. We've talked on a number of calls about the fact that the systems business is an important business for us. It's a strategic business. It's one that for 3 of our subsegments, we will continue to certainly pursue, and we will generate more revenue there. But they all need to have the important criteria. We said it again in the prepared remarks, that they generate an aftermarket opportunity for us, ideally in the form of the filter devices that we sell as our core consumables. And we hadn't seen that. As we continued to peel the onion through the course of fiscal year '13, we found that there were quite a few systems opportunities that were either one-off by nature and not of appropriate margin. Or two, we didn't see the kind of the recurring revenue opportunity by way of a modular approach that we would want to take for the future. And we're not a business that wants to go after just one-off opportunities by way of our model and our strategy. We're one that wants to go after recurring revenue and ideally, again, in the form of the consumables strength. Now in terms of the financial impact to systems in the quarter, I don't want to go there too specifically, but now it did have a reasonable impact, that's associated margin, from a mixing contribution, and I mean, out of the same kind of proportion that I just spoke about as to what we've seen more generally. And there were some even lower-margin systems opportunities within that higher systems sales. So it did pretty adversely contribute to both the gross margin rate and the bottom line in the quarter.

Operator

Your next question comes from the line of Richard Eastman with Robert W. Baird.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

Just a couple of quick questions. One is, can you just help us a little bit, when I look at the gross margin, and I'm really just looking year-over-year, and in particular in Pall Life Sciences, and I'm trying to get a sense of -- gross margin overall was down 40 basis points, I believe, year-over-year in Life Sciences. And I'm just trying to get a sense of why that number and should that number drift higher going forward? We have price as a positive, we have consumable growth. At the same time, FX and I think Food & Beverage probably was a negative draw. But I'm still surprised that the price and the consumables growth in all of Pall Life Sciences didn't provide us a better year-over-year for the full year gross margin. And should that be the case going forward?

Akhil Johri

Great question, Richard. I think you had your finger on a couple of the points, one was FX, clearly. That had a significant impact in both Life Sciences and Industrials, particularly yen, right? I mean, I think we've talked about for the year, the transactional FX impact that we have experienced in our gross margin line, fourth quarter was a little more accentuated because of the yen problem. Also the other point, which is not quite as visible, is as a result of the blood divestiture, we've had some media or raw material sales, which are at very, very low margin, which are also included in the Medical business of the Life Sciences. And that brings the margin down as well. So I think the FX phenomena will probably continue again in 2014 and we have baked that into the plan. The effect of the raw material sales will come down over time and we would expect to see some improvement in the gross margin in the Life Sciences.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

And we're still capturing 100 bps plus in price in Life Sciences?

Akhil Johri

Slightly below that.

Lawrence D. Kingsley

Not quite that in the quarter or the year, Rick. But it really does, I think, first and foremost, come down to the transactional impact, i.e. the cost of goods impact from the dollar-yen pair, as Akhil said. And the other thing that's in there from an op margin perspective for Life Sciences is the increase in R&D spend, which has a fairly large impact in the quarter. Akhil, is it 40 or 50 bps?

Akhil Johri

50 bps.

Lawrence D. Kingsley

It's 50 bps.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

EBIT line.

Lawrence D. Kingsley

Yes.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

And then just 2 questions on the Pall Industrial. One is can you just give us a sense of how big does the Muni Water business, I guess, remain or how big is it? And how much was it down for the year? Is that business...

Lawrence D. Kingsley

Again, I hate to slice and dice to that degree. But just to say substantially, there's a couple end markets if you look at where systems was most impacted from a top line standpoint, the first would be Municipal Water, most of that's in North America. Second, and this is maybe telling and interesting, we do a fair amount of our systems revenue, or had historically, in some specific chemicals applications. And if you look at just what we had done historically in, for instance, polyurethane or the components that go into polyurethane, which is construction and furniture-making and things of the sort, down almost equally substantially. And a lot of that being lack of Asia content. So if you look at water and that in combination, that's almost all of the contribution to the delta that we're talking about. And again, some of that is strategic exit, some of that is not wanting to compete on a price basis. It doesn't make sense if there's no recurring revenue opportunity.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

I see. And just related to that, we are seeing quite a few U.S., at least, nuclear plant shutdowns. And some of the relicensing is either held up or some of the relicense applications have been canceled. And so the question I have, I know Pall is a big player in that nuclear water space, is that big enough to have an impact here as we go forward, in the energy piece?

Lawrence D. Kingsley

It's a slight headwind. For sure, we do, to your point, do well in Power Generation in nuclear globally. And if plants shut down at a fast pace globally, then yes, in aggregate, it could have an impact to us as we look forward. The number of plants that have been announced that are going to shut their doors in the U.S. and as a percentage of the global content isn't huge. And again, the dynamics globally of energy cost, natural gas versus other forms of fossil fuel and other alternative fuels, isn't as dramatic going forward as it is here in the States. So I don't think you can get too concerned about it at this point.

Operator

Your next question comes from the line of Derik De Bruin with Bank of America.

Derik De Bruin - BofA Merrill Lynch, Research Division

So a couple of housekeeping questions initially. In terms of the share repos, how do we think about pacing through the year? Are you going to front end-load those? Or are those going to be evenly distributed?

Lawrence D. Kingsley

Likely front end-loaded.

Derik De Bruin - BofA Merrill Lynch, Research Division

Okay. What's built into your local currency assumptions for geographic growth for the year, for 2014?

Lawrence D. Kingsley

It's not radically different than last year. But just from a country-specific domicile standpoint, a little bit different. And hence, the tax rate comments that we made.

Derik De Bruin - BofA Merrill Lynch, Research Division

Got it. And then on the -- going to the systems comments again, just particularly thinking in your Life Sciences business, obviously there's been a -- there's more of a shift away from stainless steel to single-use systems in the bio-manufacturing market. I guess, can you talk about what products you've been introducing in that area and also sort of what you're seeing in that market? How is that sort of impacting your overall Life Sciences margin? I assume these are obviously much higher margin, the single-use products. Just curious about how your sort of R&D pipeline is building out there.

Lawrence D. Kingsley

Yes, it's a good question. Derik, so there is without a doubt a continued trend for some portion of the bioprocess environment to move towards single use versus the traditional stainless steel architectures. And the good news is we're doing well with that. Our growth rates for single use-based applications are substantially higher than the -- call it the older, more traditional forms, where filtration was a smaller component of the solution. In terms of big picture and how it impacts us, we get a lot more content out of a single use-based system than we did out of the former stainless equivalent. And unfortunately, I wouldn't say the margin rate is incremental going forward. It's slightly dilutive. And on an absolute basis, it works to our favor, just given the more share of wallet. So we are investing. Some of that incremental R&D that we talk about is all about single use. We're continuing to invest right now in single use. We think that we're arguably 1 or 2 in the world in terms of best product, best basket, going forward, of technologies. And some of that IP that we spoke about is single-use focus. So I think we're in great shape as the industry does continue to migrate. So I think the story going forward will be better growth as a function of it.

Derik De Bruin - BofA Merrill Lynch, Research Division

And also sticking with BioPharma, if you look at 2014, are you expecting -- what's sort of built in for major new drug launches or extensions there? I mean, are you seeing any specific new bolus of activity as new drug comes online? I'm just curious in terms of how you're thinking about the overall end market there.

Lawrence D. Kingsley

It actually doesn't impact or correlate with our BioPharm growth rate to the degree that maybe you would expect. And so we spend a fair amount of time with making sure that we're on top of all the global biotech providers and that we're certainly there at the point of specification. But big drugs coming on or offline has a fairly muted impact to our overall top line, not just within the year, but within the couple years that you might expect that you'd see the swing. Now we don't see it as a year-over-year headwind in any form for us in '14. As a matter of fact, we've got the growth rates for BioPharm for '14 pegged at a pretty nice clip, call it mid- to high single-digit assumption.

Derik De Bruin - BofA Merrill Lynch, Research Division

Great. And just this one final question, what are you assuming for the top line impact from FX? What's the -- is it about 1 to 2 points in growth?

Akhil Johri

No, it's actually less than that. It's about 50 basis points.

Operator

Your next question comes from the line of David Rose with Wedbush Securities.

David L. Rose - Wedbush Securities Inc., Research Division

A couple of questions on growth into next year. I mean, you talked about the end markets. And historically -- and you helped today by talking about the IP. I was wondering if you can talk a little bit about it, about product development. And how should we think about the vitality index? It's a lagging indicator, but you're farther along now than we were a year ago, when we started talking about investment in R&D. Can you give us a little bit of color on how should we think about new products as a percentage of sales or some sort of vitality index, maybe even into 2015, if we could?

Lawrence D. Kingsley

Well, I think, honestly, it's going to be a less-than-fulfilling answer. And it's not an excuse or a Pall-specific issue. It is a lagging indicator, and sometimes quite a bit, depending on the ramp-up time associated with that vitality to the specific revenue that gets generated. The good news is that we spent quite a bit, '13 versus '12 year-over-year, in terms of incremental R&D. And we're going to see a little bit of an increase, a modest increase in '14 versus '13. But we have gotten to the point now where we're much more focused and our marketing teams are providing great direction as to better product for the application at the right time. So our returns are stronger on the resources that we're investing. I think that we'll probably -- and I don't want to give you a baseline and target numbers, which are frankly part of our internal goal set, but we're going to see a few points per year of vitality increase. The objective is to get to, frankly, the best vitality in the world of filtration. And that's coming off of a softer position as of a couple years ago. So it's headed in the right direction pretty quickly. The proof is that we're seeing direct new wins at customers already. That's in BioPharm and MicroE and certain other industrial applications, where we can tie it directly to the product development success that we've already begun to achieve.

David L. Rose - Wedbush Securities Inc., Research Division

So the top line assumptions for 2014, are they including new product development or new products? Or are you assuming simply end markets perform as they do?

Lawrence D. Kingsley

Well, the short answer is yes. Our top line assumptions that we've been talking to today include some share gain, I would call it very limited, associated with improved vitality, as a result of how we're starting to tremendously improve the technology that we incorporate in the new devices.

David L. Rose - Wedbush Securities Inc., Research Division

Okay. That's helpful. And then lastly, can you speak to some of the operating initiatives or the progress you made? Last conversation that we had, it was really kind of a China and the actions that you were taking to fix operations there, particularly in the industrial side. Can you walk us through some key initiatives that were undertaken in the quarter and successes and failures on those?

Lawrence D. Kingsley

Yes, sure. In terms of operations -- when I refer to operations, I tend to be thinking about manufacturing, supply chain and the kind of the more specific definition of operations. But it was a fabulous year and the team's done a wonderful job building in now true productivity in the sense that you'd expect a Lean or Six Sigma group of experts to basically kind of set their agenda around. We have, in many of our plants, not all of them, started to see great productivity when you look at both the touch and indirect labor per product or per revenue dollar or euro, or whatever the case may be. And what we're seeing in the way of adverse impacts, specifically what Akhil talked to around the transactional inherent cost that we saw with currency pairs through the year, unfortunately kind of mutes some what would've been pretty impressive gross margin year-over-year performance. But it is what it is. Along those lines, we have announced that we're moving a number of facilities. We've integrated 4 that we've talked about to varying degrees through the course of '13. We're in process with them. We've also announced that we're opening a new facility in Slovakia, which will give us additional capability to build product in a euro-denominated fashion. And so if you think about how we get to the point of a more flexible labor capability, one that is not so exposed to the FX movement, most of our operational initiatives are right on track with what we have been talking about externally and what internally we've been focused on. In terms of the operations customer service performance, as I alluded to in my prepared remarks, it's been fabulous. We have better-than-average customer service metrics now, and that's coming off of a pretty tough starting point. So I think that it's all within our control in terms of ability to win. It's about tasking the front end of the organization. That's the sales and marketing team, with taking advantage of great performance going forward and how we use it to our advantage strategically, and in tactical head-to-head situations with competitors. Beyond operations, in terms of things that have gone well, we've talked a number of times about getting our SG&A in line with the peer group. There's still a couple of points of opportunity there in terms of what would make sense for a business of our profile. So you translate that to cost and over a longer period of time, it's a $50-plus million opportunity to get us, just frankly, in line with what might make sense for someone of our profile. Good news is we've demonstrated we can do it. We've got our house, I would say, in order, but there's more to come. And that's the opportunity for how we do it. And hopefully, by way of growth, that's the most delicate way. I think the internal 2013 initiative set was largely accomplished. And we feel pretty good about our ability now to take that forward still in terms of action set. But also, as I said, in terms of thinking through cost as it helps us with incremental margins, we're kind of getting to the point where I wanted to get to at this stage.

Operator

Your next question comes from the line of Jeff Zekauskas with JPMorgan.

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

It's Silke Kueck for Jeff. A couple of questions. I wonder whether you can, like, walk through where the -- what is the new assumption for first quarter earnings being at a level lower than first quarter, because it does seem that the industrial businesses have picked up. I mean, the businesses on the margin is better than I would've expected, and so they seem to be at a higher run rate than they were in the beginning of the year. It seems there were some specific Aerospace issues having to do with some helicopter business, which probably won't repeat. And so I was like a little bit puzzled as to why you thought the first quarter would be equivalent or maybe lower than the first quarter a year ago.

Akhil Johri

Sure. Firstly, just one data point on the Aerospace comment that you made. The point was more about orders in fourth quarter of '12, not necessarily an issue with fourth quarter of '13. So the run rate doesn't necessarily change going from Q4 '13 to Q1 '14. That's just a data point for your reference. But more importantly, if you look at our orders and the book-to-bill, we haven't quite seen the turnaround in the industrial space that you're talking about. Most of our customers are also suggesting that, yes, there is an improvement expected, perhaps we have bottomed out. But in terms of an uptick, it's not yet visible, either in our order data or in terms of conversations with customers. It's more second half of our fiscal year or first half of calendar '14 when the industrial activity is expected to pick up significantly. And once we start to see that in our order base, then we will have more confidence in that. So that's point number one. Point number two, I think Larry talked about the fact that we had significant operational improvements in 2013 and our back orders went from $25 million to $7 million during the course of the year. A part of that exceptional performance was also in Q1, which then makes the compares a little bit more difficult because we don't have that much more to sort of improve, if you will, in terms of back order reduction. So compares like that is what is concerning. The third point I would make is the transaction FX impact, particularly with yen compares Q1 this year versus Q1 last year, is going to be pretty significant as well, right? So those are the things that make us cautious about Q1.

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

Okay, that's helpful. Secondly, I was wondering where you stood now with the implementation of your ERP systems and SAP systems. Is that complete? Or are there any regions that you're still trying to hope to complete? And what improvement do you expect from that?

Lawrence D. Kingsley

No, it's essentially complete and it has been for a quarter. There are some sales offices and application centers and things of the sort that are still coming online, but it's 99.5% complete.

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

Okay. And then lastly, in terms of M&A, it always seems that there are sort of smaller companies out there with like interesting membrane technologies, and sometimes it makes sense to buy them before somebody else does. So is there anything -- like if you were looking at new technologies, like which areas you're looking at? And do you think you'll make an acquisition next year?

Lawrence D. Kingsley

Yes. We're always making technology investments, many of which we don't talk about. And in this environment where M&A is a bit frothy, actually we've diverted a portion of our business development strategy to going after technology that we bring in. And we do it in various forms, either through licensing or some kind of venture interest or otherwise. And those are in multiple areas. It's in, frankly, many areas that support our MicroE and BioPharm application set. But really in our case, our core technology serves most of the end markets. So yes, we're in process with that. We did some of that in 2013, we'll do more in 2014.

Operator

Your next question comes from Paul Knight with Capital Markets.

Paul Richard Knight - Janney Montgomery Scott LLC

It's Paul Knight at Janney. The internal initiatives you said were at what point in the Asian operations?

Lawrence D. Kingsley

Repeat your question, Paul?

Paul Richard Knight - Janney Montgomery Scott LLC

The initiatives in China were at what stage, you were done with the reorg there or not done?

Lawrence D. Kingsley

Yes, we are done with the reorg in Asia broadly and in China. And we believe we've turned the corner in terms of everything necessary for us to execute. I would still say that China is a set of markets that's going through still the transformation that everyone's talking about. But we had good growth in the fourth quarter in China, very good. And Asia broadly is showing much more positive signs in terms of our ability to take share. So there's undoubtedly, I think, a whole next set of chapters ahead of us as Pall in China based on the fair amount of legwork done through '13 to get the house there in order.

Paul Richard Knight - Janney Montgomery Scott LLC

Is the emerging markets growing -- do you think will continue to grow, what, twice as fast as the corporate average?

Lawrence D. Kingsley

That's a good question. I would say maybe not quite that much, because again, you have some emerging markets that are in a bit of a quandary as to where they're headed. India would be the best example, I think, right now and others that are still trying to transition from infrastructure-based growth to consumables or consumer economies. And that will make it a little more difficult for any company that's of a profile like ours. So I'd say maybe not 2x, but certainly more than the developed world.

Paul Richard Knight - Janney Montgomery Scott LLC

Yes, and then lastly, are you starting to see interest from the early-stage biotechs that now are getting capital raised, are you seeing business emerge yet from that category of customer?

Lawrence D. Kingsley

Well, we do tend to get early-stage revenue directly from many of them, who are in even just the research phase. So yes, we do. In terms of where our revenue is derived, if you were to look at the big guys around the world that are biotech-specific or big pharma that have portions of their business that they have acquired in the space, that would be the bigger chunks of our pie chart for BioPharm.

Paul Richard Knight - Janney Montgomery Scott LLC

So to the biotech IPO world eventually helps, right?

Lawrence D. Kingsley

Oh, absolutely.

Operator

Your next question comes from the line of Jon Groberg with Macquarie.

Jonathan P. Groberg - Macquarie Research

So Larry, I guess, you've been there for a little bit now, and I'm still trying to just maybe get a feel for how you're thinking about guiding, going back to '13, looking at how you started off the year and how the year kind of ultimately played out. And then I recognize the challenge inherent in Pall in terms of forecasting some of the niche businesses that they're on. But can you maybe, just kind of from the top line, just help us understand how you're forecasting growth? Are there certain GDP, certain macro assumptions that you're making? I think, I know you mentioned you thought maybe industrial would pick up in the first part of the calendar year of '14. But just help us understand how much is kind of top-down, how much is bottoms-up. I know you made some comments around share. But I think it seems like -- it seems at this point, a lot of the EPS growth that we hope to get is going to be more dependent on revenue growth, obviously. So I'm just trying to understand that.

Lawrence D. Kingsley

It's a yes and no answer to the last portion of your question. But let me back up and give you some more quantitative color, if you can kind of think through it with me. And so first, relative to last year, yes, obviously, when we guided at this point last year and we got to even the middle part of the quarter, many of our large customers, whether they were end users or OEMs, were doing a complete change in terms of their expectation for their years, what remained of their calendar years or their outlooks. And they were changing their demand that they were placing on us pretty radically. So that didn't serve us too well from an accuracy perspective, as you know, if you remember from the 12-month-ago discussion. I think we're getting much better though, to answer your question around whether we're more accurate on how we think about forecasting and how we're driving it as a process in the company. It's cross-functional. It's certainly far from perfection, but it's getting better. Now relative to the inherent components of how we're thinking about it, it's as follows. So we're assuming that consumables for the full corporation are going to grow somewhere between, call it, 3% and 6%. I'll be more specific. Life Sciences, a little higher than that for the consumables contribution. And the Industrial portion is a little bit more of a range, with something in the kind of minus 3% to plus 3% range. So then what mutes that is the systems performance. And again, you can see that by way of looking at the order rates that we provide. All of that yields better mix, as we've talked about, so that helps. And certainly, there's, I think, a pretty logical and good means for explanation around the Industrial range at this point, just given the uncertainty that globally still exists. So you can do the math. But what you get to is worst case, real worst case, that total consumables is flat or shrinks very slightly. Best case is it's 4-ish percent, something in that neighborhood, inclusive of the systems -- sorry, exclusive of the systems.

Akhil Johri

Yes. Just to -- on the second point you made, I would disagree. I don't think this is a revenue-based plan at all. I think the guidance, if you heard us before, 50% incremental margins certainly talks about significant benefit from cost side, continuing benefit of the cost reduction initiatives that Larry had launched a year or so ago, $25 million from that, plus other controls over our SG&A. We're talking about 100 basis points improvement in SG&A. That is not revenue-dependent. So I wouldn't say that this is quite a revenue-based plan.

Jonathan P. Groberg - Macquarie Research

Sure. Sorry, maybe I wasn't clear. I was just thinking where your revenue growth targets from 2013 start in your EPS guidance and kind of where you ended up. And I'm thinking if there's upside to the number, I recognize what you're saying about your existing guidance. But I'm just trying to think about how the forecasting is working on the top line, because we all understand the cost initiatives. But at some point, to the points you guys have been making on the call, you need some revenue growth, right? So that's what I was trying to get at, but that's helpful. And then can you maybe talk a little bit -- you mentioned the significant decline in CapEx. Can you talk about where that's going to be at in 2014 and what your free cash flow is going to be in 2014? And given your comments around the buyback and M&A and prices still being expensive, maybe a little bit more detail around if you're still -- I'm guessing you're still going to have a pretty good position from a capital deployment standpoint. So maybe what you're thinking about, why not be more aggressive with the buyback if it sounds like there aren't any significant deals available at the moment?

Lawrence D. Kingsley

Yes, I mean, it's consistent with what you'd expect for, I think, a good operating company. Basically, CapEx ought to be at the depreciation rate, and we're still working our way there. The good news is once we got beyond the ERP system deployment and we got to, I think, a better understanding of how we can improve productivity within our factories, there really isn't the massive bricks-and-mortar need going forward. And we can actually continue to grow this company substantially without having to spend too much on the pure plant portion of PP&E. Relative to where capital gets spent, it's largely in support a new product development in both the front end of the business and in operations, so tooling and things of the sort to get product to market, the actual equipment on the floor. But I think that's the easy math relative to what CapEx needs to look like going forward for the long term of the company. In terms of free cash, we're looking for free cash to kind of be at the net income rate. And this company has not historically performed there, but we will. And if you look at the back half of '13, we did very well. And again, it's evidence of the house becoming -- we're getting it in order. We're doing pretty well, frankly, now in terms of how we think about return on investment for all initiatives that consume our capital. Now in the -- how you think about that in the broader scheme of things and the capital allocation strategy, we've had a number of conversations, both within management and with our board, as to what makes sense. And certainly, the primary use, the longer-term plan, is acquisitively focused or disproportionately associated with acquisition. But as we've said, and almost everyone else have said, there's a pretty high-priced M&A market out there right now. And you've got to be smart about which acquisitions you want to make in this kind of environment. That doesn't mean you don't do them, but you do them very prudently. And we are pursuing those. Now with respect to the short term, we spoke in the prepared remarks of the $250 million share repurchase assumption is the current thinking of management and the board. And does that change if we don't acquire in the mid-term? Perhaps. But for now, we think we're taking a kind of balanced perspective, a balanced approach, toward what makes sense in terms of capital allocation.

Operator

Your next question comes from the line of Brian Drab with William Blair.

Brian Drab - William Blair & Company L.L.C., Research Division

Most have been answered, but -- so why wasn't SG&A down a little bit more in 4Q? Could you just talk about, maybe I missed this, but some of the factors that, given relatively flat revenue, we didn't see SG&A tick down a little bit more in the fourth quarter?

Akhil Johri

Yes, I think, Brian, a little bit of that was some catch-up accruals we had to take for some outperformance in certain segments of our market, particularly Life Sciences, related with sales incentive plans. And also some catch-up accruals associated with a few other things. So it wasn't a change in trend of any kind. It wasn't like suddenly the brakes have come off. It's just an artifact of how the quarter came together. We were still flat as a percent of sales on SG&A in the quarter. And for the year, we were about 100 basis points down, which is our goal for next year as well.

Brian Drab - William Blair & Company L.L.C., Research Division

Right. Yes, the performance for the year was excellent. Okay, so that clarification on the fourth quarter helps. And then in the guidance, you mentioned that R&D will be down modestly. Is that in terms of absolute dollars, percentage of sales or both?

Akhil Johri

It could be up.

Lawrence D. Kingsley

Up modestly.

Brian Drab - William Blair & Company L.L.C., Research Division

I mean, sorry, it's going to be up modestly. Is that in terms of absolute dollars or a percentage of sales or both?

Akhil Johri

I think it's probably both, Brian, but not to the level that you saw this year.

Lawrence D. Kingsley

Depends on the sales.

Brian Drab - William Blair & Company L.L.C., Research Division

Right. Sure. So then I was looking at -- Akhil, you mentioned earlier in the Q&A, I think it was the first question, around incremental operating margin. The number, if I use the assumption that R&D is up modestly, hold gross margin about steady, I get to that, I think you mentioned, 50% incremental operating margin. I'm getting 43%, 45%, 50%, depending on the assumptions around sales growth. Is that more aggressive or better than you expected? It's above the 35% or 40%, I think, that Larry had talked about in the past.

Akhil Johri

Yes, it is to some extent and it is a little bit benefited by the cost reduction actions that had been launched earlier, Brian. So I think on a normal basis, Larry's math was 35% to 40%. If you take in the extra benefit of the special initiatives on cost reduction, you get to the higher number that you are computing. And as you appropriately said, it will be a function of sales as to where the incremental margin ends up. We think we are appropriately calibrated in terms of the guidance. And again, depending on -- the good news is that the operating leverage of the company is very strong. And if the revenue comes in better, I think we'll convert nicely. And if the revenue doesn't, then at least we'll deliver on this guidance.

Brian Drab - William Blair & Company L.L.C., Research Division

Okay. And then just one more quick question. The consumables as a percentage of sales has been higher than historical lately. This quarter, 87% to 88% [ph] of sales was related to consumables. Is that due to just the paring down of the system sales? Is it due to strong growth in consumables relative to system sales just because of the markets? Or is it also maybe a difference in the reporting methodology?

Akhil Johri

No change in reporting methodology, Brian. I think this quarter was 84%, for the year is 87%. And I think if you -- what Larry said earlier, we have had systems somewhere between 12% to 15% of our sales over the last 5 years. So a little bit of the reduction in systems is just the environment with the tightness on capital spend on our customer side. Part of this is self-selection. As Larry had said, strategically, we are trying to reduce or limit our systems business in areas where there is no annuity or no consumables stream. But overall, I think it's probably that 13% systems is where we ended up in '13, fiscal '13, and maybe it's slightly lower for fiscal '14.

Operator

Your next question is a follow-up from Richard Eastman with Robert W. Baird.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

On the fiscal '14, on the sales guidance, you touched on this a little bit earlier. Consumables are maybe up 3% to 6% or 4% at the midpoint. The systems piece, obviously then, you're minus 3% or probably plus 3%. It looks like the systems backlog in the P&I business is maybe down mid-teens. So is the risk in the sales forecast systems-oriented, and in particular, we need some bookings in the first half for the year on the PI side of the business?

Lawrence D. Kingsley

You could say that. That's a good summary statement. And the worst case, as it impacts systems revenue, yes, you get to the numbers that you're solving for. Again, from a mix perspective, it doesn't necessarily have an adverse impact to profitability for the company. But if you want to just think about organic growth, the risk relative to both order rate and backlog, as it prints to revenue in '14, is in PI systems.

Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then second, is there a price assumption, just consolidated, in '14?

Lawrence D. Kingsley

Yes, it's not huge, just kind of on par with '13.

Operator

At this time, there are no additional questions in the queue. I'll turn it back over to management for closing remarks.

Lawrence D. Kingsley

Well, thank you all for joining. Before I close though, I just want to thank our team, our management team and our broad employee population, for executing a great year in the face of slower top line performance. Particularly, I would say our operations group globally and our European sales team just did a phenomenal job, as you've all witnessed through the course of the year. And I think we're off to a good start in '14. We look forward to talking to you through the course of the quarter and several weeks from now on the call. Thank you.

Operator

This concludes today's conference call. You may now disconnect. Speakers, please hold the line.

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